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Cyprus Bailout Proposal Sets Dangerous Precedent

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Tuesday, Cyprus' parliament voted 36-0, with 19 abstentions, to reject the terms of a proposed bailout package, which would have required Cyprus to raise 5.8 billion euros in conjunction with a 10 billion euro aid package from the Eurozone. The proposal stipulated Cyprus would raise the money by seizing bank deposits and drew harsh criticism. Professor Robin Lumsdaine, Crown Prince of Bahrain Professor of International Finance, discussed the implications of such a bailout for Cyprus and beyond.

Q. What precipitated the bailout and what were the key terms?

A. Basically, Cyprus was facing a likely default on its debt, that is, not having the cash on hand to meet its current obligations. Cyprus sought aid to enable it to fulfill its obligations and avoid default. The initial proposal was to collect 6.75 percent of bank deposits less than 100,000 euros and 9.9 percent of deposits more than 100,000 euros.

Q. Why were people upset about the bailout terms?

A. There were a number of reasons. First, as recently as a week ago, Cyprus' leadership flatly denied that such a levy would be imposed. Second, the proposed structure was viewed as extremely regressive—i.e., even those with very little savings were being asked to bear some of the burden. Third, a "bank holiday" was declared—meaning people were unable to access their funds (banks in the country remain closed). Fourth, depositors in the Eurozone had been led to believe their deposits were safe as a result of deposit insurance—essentially guaranteeing deposits below a certain threshold—the proposal highlighted the fragility of such a guarantee. Hence, in addition to the panic of Cyprus' depositors, there was a real fear was that the proposal would cause not just a run on Cypriot banks but on banks throughout the Eurozone. Fifth, it is unusual to go after individual deposits before exploring more traditional approaches, e.g., haircutting the debt.

Q. What are the implications of the proposal rejection?

That remains to be seen. There is no doubt that a lot of negotiations are going on behind the scenes to develop alternative proposals. There are a lot of rumors swirling around, similar to those we saw with Greece, regarding what happens if Cyprus does indeed default and/or whether there might be a potential exit from the euro. At this point the uncertainty as to what will happen makes the situation much worse. The main challenge (now that a deposit levy has been put on the table) is figuring out a way to reopen the banks while avoiding a massive deposit outflow – such an outflow would greatly exacerbate the situation.